Background

A. Regulation SHO and Short Selling

Regulation SHO establishes a regulatory framework to govern short sales. The term short selling refers to the sale of a security that the seller does not own, or any sale that is consummated by the delivery of a security that was borrowed by, or for the account of, the seller. To deliver the security to the buyer, the short seller will borrow securities, usually from a broker-dealer or institutional investor. The short seller later closes-out the position by purchasing equivalent securities on the open market. Generally, short selling is used to profit from an expected downward price movement. Short selling can provide liquidity in response to unanticipated demand, or function as a hedge to the risk of a long position in the same security or a related security.

B. Regulation SHO's Close-Out Requirement

Among other things, Regulation SHO includes a close-out requirement intended to address persistent failures to deliver stock on trade settlement date ("fails to deliver"). A "fail to deliver" occurs when a broker-dealer fails to deliver securities to the party on the other side of the transaction on settlement date (i.e., T+3). Regulation SHO's close-out requirement provides that a participant of a registered clearing agency must take immediate action to close-out fails to deliver. On October 14, 2008, the Commission adopted Rule 204T of Regulation SHO as an interim final temporary rule that temporarily enhances the delivery requirements for sales of all equity securities.2 The temporary rule expires on July 31, 2009.

The participant must close-out such fails to deliver by purchasing securities of like kind and quantity. Until the position is closed out, the participant and any broker-dealer for which it clears transactions, including market makers, may not effect further short sales in that security without borrowing or entering into a bona fide arrangement to borrow the security until the participant closes out the entire fail to deliver position by purchasing securities of like kind and quantity (also known as the "pre-borrow" requirement).

C. The Options Market Maker Exception and its Elimination

Prior to this amendment, Regulation SHO contained an exception to the rule's close-out requirement under Rule 203(b)(3)(iii) that excepted from the close-out requirement fails to deliver resulting from short sales by registered options market makers effected to establish or maintain a hedge on certain options positions. The Commission amended Regulation SHO to eliminate the options market maker exception to the rule's close-out requirement.

How does the amendment to Regulation SHO affect small entities?

Small entities that are participants of a registered clearing agency, and small broker-dealers for which a participant of a registered clearing agency clears trades or for which it is responsible for settlement are affected by the amendment. Additionally, small entities that effect short sales subject to the requirements of Regulation SHO are also subject to this amendment.

The amendment to eliminate the options market maker exception to Regulation SHO's close-out requirement imposes minimal new or additional reporting, recordkeeping, or compliance costs on broker-dealers that are small entities. In order to comply with Regulation SHO when it became effective, entities needed to modify their systems and surveillance mechanisms. Thus, the infrastructure necessary to comply with the amendment to eliminate the options market maker exception should already be in place. Any additional changes to the infrastructure should be minimal. In addition, entities subject to Regulation SHO's close-out requirements should already have systems in place to close out non-excepted fails to deliver as required by Regulation SHO.

Contacting the Securities and Exchange Commission

The Commission's Division of Trading and Markets is happy to assist small entities with questions regarding this amendment to Regulation SHO. The Division's Office of Interpretation and Guidance answers questions submitted by telephone at (202) 551-5777, or via e-mail at tradingandmarkets@sec.gov.

1 This guide was prepared by the staff of the U.S. Securities and Exchange Commission as a "small entity compliance guide" under Section 212 of the Small Business Regulatory Enforcement Fairness Act of 1996 as amended. The guide summarizes and explains rules adopted by the Commission, but is not a substitute for any rule itself. Only the rule itself can provide complete and definitive information regarding its requirements.